Edition #62
My Thoughts on the FOMC Policy Meeting (July 27 & 28)
In anticipation of the FOMC policy meeting held this week, the markets have been quite stagnant in the lead up to Jerome Powell’s press conference yesterday afternoon. As has been the case for the last 12-16 months, there hasn’t been any question about what the Fed’s policy decision would be in terms of the federal funds rate. In fact, the target range of the FFR has remained between 0-0.25% since the initial response to the pandemic.
In light of the resilience of the U.S. economy, widespread adoption of the vaccine (thus reducing social distancing guidelines & shutdowns), higher expectations of economic growth, record-high asset prices, and higher-than-expected inflation, the market has turned its focus towards when the Federal Reserve will begin to transition away from their zero interest rate policy (ZIRP). The market understands that the path towards raising interest rates will be the same as it was in the wake of the Great Recession, and this has even been confirmed by the Fed now for several months. Initially, the Fed will begin to reduce the magnitude of its asset purchases, but remain a net buyer of both U.S. Treasuries & agency-MBS. The Fed has been committed to purchasing at least $80Bn/month in Treasuries & $40Bn/month in MBS, therefore both of these figures will move closer to zero as the Fed tapers its asset purchases. If/when the Fed achieves a net-zero rate of asset purchases, the next step will be to unwind the balance sheet by selling off its remaining Treasuries & MBS that remain in their possession. This final step is referred to as the “tightening” process, in which liquidity is metaphorically sucked out of the financial/economic system.
The key thing to note is that the tapering phase is still accommodative, just not as accommodative as the current monetary stimulus. It’s essentially the equivalent of switching from a double-shot glass to a single-shot glass when you’re drinking tequila — you’ll still get drunk, just not as rapidly as the double-shot glass. The market is so concerned with this phase because it’s become conditioned to the current magnitude of monetary stimulus and liquidity injections. In my opinion, the tapering process will not begin until Q1 2022. Five minutes prior to the FOMC policy statement & press conference, I posted the following on Twitter:
The liftoff phase, in which the Fed will begin to actually sell securities & tighten monetary conditions, is too far ahead to be able to reasonably predict if/when it will happen. For all we know, we could face another exogenously-caused recession in the next 2 years that would force the Fed to remain hyper-accommodative. We just don’t know. With that said, I think it’s unreasonable to expect the Fed to raise rates any time before January 2023.
With that background out of the way, I wanted to provide some of the most important quotes & takeaways from today’s FOMC policy statement & press conference. All quotes are directly from Jerome Powell. Everything in italics is solely my own opinion or my own additional commentary.
“Household spending is rising at an especially rapid pace, boosted by an ongoing reopening of the economy & ongoing policy support.” This is self-explanatory & doesn’t really need much color. We continue to see strong consumer data, strong levels of both consumer & business confidence, and rising demand as the labor market trends in a positive direction.
“Housing sector remains very strong & business investment is increasing at a solid pace.” I wholeheartedly agree with this brief statement on the housing sector, although I believe this is a massive understatement. The housing market is historically strong, not just “very” strong. I’d also push back on the statement regarding business investment. While business investment is growing at a solid pace, the growth is fairly anemic. We aren’t seeing a substantial increase in commercial loans, which would imply that businesses are borrowing in order to expand production, conduct M&A activity, etc. In fact, per the Fed’s recent data release on industrial production, they only observed a +0.4% increase in June 2021 and a +0.7% increase in May. As I said, that’s relatively anemic.
“Conditions in the labor market have continued to improve. Demand for labor is very strong, and employment rose 850,000 in June, with the leisure & hospitality sector continuing to post notable gains. Nonetheless, the labor market has a ways to go.” I agree with all of this, and I believe this will continue to play an important role in terms of remaining patient in tapering. The labor market, as we’ve covered, remains strong from the demand side (ie. potential employers are desperate to hire high-skilled labor), but remains weak in terms of supply (ie. available high-skilled labor willing to accept a job at existing wages).
“Inflation has increased notably & will likely remain elevated in coming months before moderating. As the economy continues to reopen & spending rebounds, we are seeing upward pressure on prices particularly because supply bottlenecks in some sectors have limited how quickly production can respond in the near-term. These bottleneck effects have been larger than anticipated, but as these transitory supply effects abate, inflation is expected to drop back toward our longer-run goal.” Of course, I agree with all of this as well. We’ve covered inflation data at length here on this newsletter & have been keeping up with all major data, leading indicators, and a variety of supply-chain related data.
“Indicators of long-term inflation expectations appear broadly consistent with our longer-run inflation goal of 2%. If we saw signs that the path of inflation or longer-term inflation expectations were moving materially & persistently beyond levels consistent with our goal, we’d be prepared to adjust the stance of policy.” The purpose of this statement is to reassure the market that the Fed is willing and able to curtail inflation if/when it decides to take action. This kind of posturing is important for the market to see, and there is a lot of truth to the fact that the Fed has the tools to handle inflation. The issue is, if they wait too long, many economists believe that suppressing inflation will be equivalent to trying to catch a dog by its tail — very difficult.
“With regard to interest rates, we continue to expect that it will be appropriate to maintain the current zero to ¼ percent target range for the Federal funds rate until labor market conditions have reached levels consistent with the committee’s assessment of maximum employment, and inflation has risen to 2% and is on track to moderately exceed 2% for some time”. The Fed has made it clear for a very long time which conditions must be met in order for them to tone down monetary stimulus. The language they use gives them flexibility & discretion as to when and how significantly they will act. In my opinion, the somewhat ambiguous connotation of “full employment”, “moderately exceed”, and “for some time” are good tools for the Fed.
“We are continuing to increase our holdings of Treasury securities by at least $80Bn per month and of agency-MBS by at least $40Bn per month, until substantial further progress has been made toward our maximum employment & price stability goals. Our asset purchases have been a critical tool. They helped preserve financial stability & market-functioning early in the pandemic, and since then have helped foster accommodative financial conditions to support the economy. At our meeting that concluded earlier today, the committee continued to discuss the progress made toward our goals since the committee adopted its asset purchase guidance last December. We also reviewed some considerations around how our asset purchases might be adjusted, including their pace & composition, once economic conditions warrant a change. Participants expect that the economy will continue to move toward our standard of substantial further progress. In coming meetings, the committee will again assess the economies progress toward our goals, and the timing of any change in the pace of our asset purchases will depend on the incoming data.”
I want to specifically call out this final bullet point, as I believe it’s the most important thing that was said during yesterday’s statement and is the reason why I gave a lengthy introduction and explanation about tapering and tightening. In particular, the second-half is the most important. I believe that this is the second step towards announcing that they will be tapering soon. The first step has been to say that “we’re not even talking about talking about raising rates”. Yes I wrote “talking about” twice because that’s exactly what they said and meant — the Committee had not even been ready to discuss the topic of discussing tapering/raising rates. It seems we have now graduated from that stage, and are now discussing the idea of tapering and if/when it is appropriate. The next phase will be to pre-announce that they are planning to slow down their current rate of asset purchases within the next X months. We don’t know how long “X” is going to be or how much of a forewarning we’re going to receive, but Powell has reiterated that they will give the market ample time and sufficient guidance as to when that will be.
We’re still a ways away from the pre-tapering announcement, which means we’re even further away from the initiation of any tapering. This is why I feel comfortable with an estimate of Q1 2022 as the start of tapering. My motto has been, and will continue to be, “lower for longer” to insinuate that rates will remain at 0% for longer than economists & the market believes. As such, I reiterate my positive outlook on U.S. stocks & dollar-denominated assets over the medium & long-term.
Until tomorrow,
Caleb Franzen